Alternative

Investments
-- 2017
Instructor: Jie
 Brief Introduction
Topic weight:
Study Session 1-2 Ethics & Professional Standards 10%-15%
Study Session 3 Quantitative Analysis 5%-10%
Study Session 4 Economics 5%-10%
Study Session 5-6 Financial Reporting and Analysis 15%-20%
Study Session 7-8 Corporate Finance 5%-15%
Study Session 9-11 Equity Valuation 15%-25%
Study Session 12-13 Fixed Income 10%-20%
Study Session 14 Derivative Investment 5%-15%
Study Session 15 Alternative Investment 5%-10%
Study Session 16-17 Portfolio Management 5%-10%
Weights: 100%
Brief Introduction
Content:
Ø Study Session 15: Alternative Investments
• Reading 43: Private Real Estate Investments
• Reading 44: Publicly Traded Real Estate Securities
• Reading 45: Private Equity Valuation
• Reading 46: Commodities and Commodity Derivatives: An Introduction
 Brief Introduction
Exam-importance ranking:
• Reading 43: Private Real Estate Investments
• Reading 44: Publicly Traded Real Estate Securities
• Reading 45: Private Equity Valuation
• Reading 46: Commodities and Commodity Derivatives: An Introduction
Brief Introduction
考纲对比:
Ø 与2016年相比，2017年的考纲更换了“大宗商品”这一章节。
主题不变，但内容做了较大调整。
Brief Introduction
学习建议:

Ø 本课程总体难度不高，知识点与其他课程（权益，财报，衍生品
等）有交集

Ø 重点掌握各另类资产的特征和估值方法

Ø 一定要掌握课程中重点强调的知识

Ø 建议做原版教材章节后练习题和历年模考题
 Basics of Real Estate
Tasks:
Ø Classify and describe basic forms of real estate investments
Ø Describe the characteristics, the classification, and basic segments of real
estate
Ø Describe commercial property types, including their distinctive investment
characteristics
Basic Forms of Real Estate Investments

Equity Debt

Direct investments such as sole

Private ownership, or indirectly through
mortgages
partnerships and commingled
real estate funds

Publicly
Shares of real estate operating mortgage-backed
traded
companies (REOCs) and REITs securities (MBS)
Basic Forms of Real Estate Investments
Ø Private investments involve larger investment because of the
indivisibility of real estate property and are illiquid.
Ø Publicly traded real estate investments are more liquid and
diversified
Ø Debt investors typically do not participate in any appreciation in
value of the underlying real estate
Ø Returns to equity investors include income and capital appreciation
 Real Estate Characteristics
Ø Heterogeneity and fixed location
• Buildings differ in use, size, location, age, type of construction,
quality, and tenant and leasing arrangements
Ø High unit value
Ø Management intensive
• Including maintaining the properties, negotiating leases, etc.
Ø High transaction costs
Ø Depreciation
Ø Need for debt capital
Ø Illiquidity
Ø Price determination is difficult
Property Classifications
Ø Residential
• Single-family
• Multi-family
Ø Non-residential
• Commercial (including residential real estate purchased with the
intent to produce income, office, industrial and warehouse, retail,
hospitality properties)
• Farmland and timberland
 Commercial Property Types
Office
Ø Demand depends heavily on employment growth
Ø The average length of lease varies globally
Ø Possible lease structure:
• Net lease requires tenants to pay operating expenses
• Gross lease requires owners to pay the operating expenses
• The owner is responsible for the operating expenses in the first year,
for every year after that, any increase in expenses above that amount
is passed through to the tenant as an “expense reimbursement”
• Upward-only rent reviews
 Commercial Property Types
Industrial and Warehouse
Ø Demand depends heavily on the overall strength of the economy and
economic growth, import and export activity
Ø Leases are often net leases
Retail
Ø Demand depends heavily on trends in consumer spending, which depends
on job and population growth, and saving rates
Ø Lease terms depend both on the quality of the property and on the size and
importance of the tenant (anchor tenants receive attractive terms)
Ø Tenants typically pay additional rent once their sales reach a certain level
(percentage lease)
 Commercial Property Types
Multi-Family
Ø Demand depends on:
• Population growth, especially for the age segment most likely to rent
apartments
• The propensity to rent in the culture
• How the cost of renting compares with the cost of owning (the ratio of
home prices to rents)
• Financing costs
Summary
Ø Importance: ☆
Ø Content:
• Basic forms of real estate investments
• Real estate characteristics
• Classifications of real estate
Ø Exam tips:
• 熟悉不动产投资形式
• 了解不动产特征
• 了解不动产分类
Investment Characteristics and Valuation
Approach
Tasks:
Ø Explain the role in a portfolio, economic value determinants, investment
characteristics, and principal risks of private real estate
Ø Compare the income, cost, and sale comparison approaches to valuing
real estate properties
 Benefits of investing in Real Estate
Ø Current income (affected by taxes and financing costs)
Ø Capital appreciation
Ø Bond-like and stock-like characteristics
Ø Inflation hedge
• Both rents and real estate prices tend to rise in an inflationary
environment
Ø Diversification (due to low correlation with other asset classes)
Ø Tax benefits
 Risk Factors in Real Estate

Business conditions(GDP, employment, Long lead time for new

income, interest rates, inflation, etc.) development

Cost and availability of capital Unexpected inflation

Demographics(size and age distribution of

the population, distribution of socio- Lack of liquidity
economic groups, etc.)

Environmental issues Availability of information

Management (asset management, and

Leverage
property management)
 Valuation Approaches
Definitions of Values
Ø Market value: the most probable sale price
Ø Investment value: the value to a particular investor, could be higher or
lower than market value depending on how well the property fits into the
investor’s portfolio, the investor’s risk tolerance, tax circumstances
Ø Value in use: the value to a particular user
Ø Mortgage lending value: the value expected to be generated in the event of
sale, irrespective of temporary fluctuations
 Valuation Approaches
Income approach
Ø The present value of the expected income from the property, including
proceeds from resale at the end of holding period
Cost approach
Ø The concept is that you should not pay more than the cost of buying vacant
land and developing a comparable property
Ø Adjustments are made to reflect the differences between the subject
property and the new property
 Valuation Approaches
Sales comparison approach
Ø The concept is you should not pay more than others are paying for similar
properties
Ø Transaction prices of comparable properties are used as benchmark,
adjustments are made to reflect the differences (size, age, location,
condition of the property, market conditions at the time of sale, etc.)
 Highest and best Use
Ø The highest and best use of a vacant site is the use that would result in the
highest value for the land
Ø Implied land value = value after completion – construction cost
Ø The construction cost includes a profit to the developer
Ø The highest and best use is not necessarily the use with the highest total
value

Apartment Office Retail

Value after 2,500,000 5,000,000 4,000,000
construction
Construction cost (2,000,000) (4,800,000) (3,000,000)

Implied land value 500,000 200,000 1,000,000

Summary
Ø Importance: ☆☆
Ø Content:
• Benefits of investing in real estate
• Risk factors in real estate
• Valuation approaches
Ø Exam tips:
• 熟悉不动产投资的好处和风险
• 理解不动产估值的三种方法
• 掌握土地的最高和最佳使用价值
 Income Approach
Tasks:
Ø Estimate and interpret the inputs to the direct capitalization and
discounted cash flow valuation methods
Ø Calculate the value of a property using the direct capitalization and
discounted cash flow methods
Ø Compare the direct capitalization and discounted cash flow valuation
methods
 Income Approach
The direct capitalization method
Ø A capitalization rate is applied to the forecasted first-year NOI
The DCF method
Ø Apply explicit growth pattern to expect future NOI stream from which a
present value is derived
 Income Approach
Net operating income (NOI)
Ø Income after deducting operating expenses such as property taxes,
insurance, maintenance, utilities, repairs but before deducting any costs
associated with financing and before deducting income taxes
Ø NOI is a before-tax unleveraged measure of income
Ø It is necessary to consider lease terms when estimating NOI
Net operating income (NOI) = Rental income at full occupancy
+ other income (such as parking)
– vacancy and collection loss
– operating expenses
 Income Approach
NOI - Example
A 50-unit apartment building rents for $1,000 per unit per month. It
currently has 45 units rented. Operating expenses, including property
taxes, insurance, maintenance, and advertising, are typically 40 percent
of effective gross income. The property manager is paid 10 percent of
effective gross income. Other income from parking and laundry is
expected to average $500 per rented unit per year. Calculate the NOI.
Income Approach
NOI – Solution

Rental income at full 50*1,000*12 600,000

occupancy
Other income 50*500 25,000
Potential gross income 625,000
Vacancy loss 5/50 or 10%*625,000 -62,500
Effective gross income 562,500
Property management 10%*562,500 -56,250
Other operating expenses 40%*562,500 -225,000
Net operating income 281,250
 Income Approach
The direct capitalization method
Ø The method capitalizes the first-year(current) NOI at a rate known as the
capitalization rate, or cap rate for short
Value = (first-year NOI)/cap rate
Ø The cap rate is lower than the discount rate because it is calculated using the
first-year NOI whereas the discount rate is applied to first-year and future
NOI
Ø When income are growing at a constant compound growth rate:
Cap rate = discount rate – growth rate
 Income Approach
The direct capitalization method
Ø The cap rate can be estimated as:
Cap rate = (first-year NOI)/sales price of comparable
Ø If tenants pay all operating costs (net lease), the cap rate derived by
dividing rent by recent sales prices of comparables is called all risks
yield (ARY)
Value = rent/ARY
Stabilized NOI
Ø If the first-year NOI is not representative of the typical first-year NOI,
use the stabilized NOI to estimate the value
 Income Approach
Valuation with a stabilized NOI – Example
A property is being purchased that requires some renovation to be
competitive with comparable properties. Renovations will be completed by
the seller at the seller’s expense. If it were already renovated, it would have
NOI of ¥9 million next year, which would be expected to increase by 3
percent per year thereafter. Investors would normally require a 12 percent
IRR (discount rate) to purchase the property after it is renovated. Because of
the renovation, the NOI will only be ¥4 million next year. But after that, the
NOI is expected to be the same as it would be if it had already been
renovated at the time of purchase. What is the price a typical investor is
willing to pay for the property?
 Income Approach
Valuation with a stabilized NOI – Solution
If the property was already renovated (and the NOI stabilized):
Value if renovated = ¥9,000,000/(0.12 – 0.03) = ¥100,000,000
The present value of the lost income is
Loss in value = ¥5,000,000/(1.12) = ¥4,464,286
Value of the property =¥100,000,000 -¥4,464,286 = ¥95,535,714
Alternatively:
{¥4,000,000 + [¥9,000,000(1.03)]/(0.12– 0.03)]}/(1.12) = ¥95,535,714
 Income Approach
The discounted cash flow method
Step 1 – Forecast the terminal value at the end of the holding period (use
direct capitalization method if NOI growth is constant).
Step 2 – Discount the NOI over the holding period and the terminal value to
present.
 Income Approach
The discounted cash flow method - Example

Net operating income (NOI) is expected to be level at $100,000 per year for
the next five years because of existing leases. Starting in Year 6, the NOI is
expected to increase to $120,000 because of lease rollovers and increase at
2 percent per year thereafter. The property value is also expected to
increase at 2 percent per year after Year 5. Investors require a 12 percent
return and expect to hold the property for five years. What is the current
value of the property?
 Income Approach
The discounted cash flow method – Solution
Step 1 Estimate resale price after five years.
Resale (residual) or “terminal” cap rate = 12% − 2% = 10%
Apply this to NOI in Year 6:
Resale = $120,000/0.10 = $1,200,000
Step 2 Discount the level NOI for the first five years and the resale price.
PMT = $100,000 FV = $1,200,000 n =5 i = 12%
Solving for PV, the current value of the property is estimated to be
$1,041,390.
Note that the implied going-in cap rate is $100,000/$1,041,390 = 9.60%.
 Income Approach
Adapting to different lease structures
Ø If the appraisal date falls between the last rent review and the next rent
review, Two methods are used:
• Term and reversion approach
ü The term rent is the fixed (current contract) rent, the reversion is
the estimated rental value
ü The values of the two components are appraised separately
using different capitalization rates
• The layer method
ü It assumes that one source of income is the current contract rent
as if it would continue indefinitely
ü Another source is the incremental rent expected after the rent
review
 Income Approach
Term and reversion approach - Example

A property was let for a five-year term three years ago at £400,000 per
year. Rent reviews occur every five years. The estimated rental value (ERV)
in the current market is £450,000, and the all risks yield (cap rate) on
comparable fully let properties is 5 percent. A lower rate of 4 percent is
considered appropriate to discount the term rent because it is less risky
than market rent (ERV). Estimate the value of the property.
 Income Approach
Term and reversion approach - Solution
Term rent £400,000
PV 2 years at 4%
Value of term rent = £754,438
Reversion to ERV £450,000
PV perpetuity at 5%
Value at rent review £450,000 ÷ 0.05 = £9,000,000
PV 2 years at 5%
Value of reversion = £8,163,265
Total capital value = £8,917,703
 Income Approach
The layer method - Example

Consider the same property as the last example. The current

contract (term) rent is to be discounted at 5 percent, and the
incremental rent is to be discounted at 6 percent. Estimate the value
of the property using the layer method.
 Income Approach
The layer method - Solution
Term rent £400,000
PV in perpetuity at 5%
Value of indefinite rent £400,000 ÷ 0.05 = £8,000,000
Incremental rent £450,000 – £400,000 = £50,000
PV perpetuity at 6% £50,000/0.06
PV 2 years at 6%
Value of incremental rent = £741,664
Total capital value = £8,741,664
 Income Approach
Advanced DCF: lease-by-lease analysis

Ø Project income from existing leases

Ø Make assumptions about lease renewals

Ø Make assumptions about operating expenses

Ø Make assumptions about capital expenditures

Ø Make assumptions about absorption of any vacant space

Ø Estimate resale value (reversion)

Ø Select discount rate to find PV of cash flows

 Differences
Ø Under the direct capitalization method, a cap rate is applied to first-
year NOI. Implicit in the cap rate is an expected increase in growth.

Ø Under the DCF method, the future cash flows, including the capital
expenditures and terminal value, are projected over the holding period
and discounted to present at the discount rate. Future growth of NOI is
explicit to the DCF method. Choosing the appropriate discount rate and
terminal cap rate are crucial as small differences in the rates can
significantly affect value.
Summary
Ø Importance: ☆☆☆
Ø Content:
• Direct capitalization methods
• The DCF methods
• The comparison of direct capitalization methods and the DCF methods
Ø Exam tips:
• 必须掌握不动产估值的直接资本化法和现金流折现法
• 能区分直接资本化法和现金流折现法
Cost and Sales Comparison Approaches
Tasks:
Ø Calculate the value of a property using the cost and sales comparison
approaches
 Cost Approach
Steps involved with applying the cost approach
1. Estimate the market value of the land.
2. Estimate the building’s replacement cost, assuming it was built today
using current construction costs and standards
3. The replacement cost is adjusted for:
Ø physical deterioration (curable and incurable)
Ø functional obsolescence
Ø locational obsolescence
Ø economic obsolescence
4. The estimated value of the land is added to the adjusted replacement
cost to obtain the estimated total value
 Cost Approach
Ø Physical deterioration is generally related to the age of the property
because the property wears out over time
• Curable deterioration means fixing the problem will add value that
is at least as great as the cost of the cure, the cost of fixing any
curable items must be deducted from the replacement cost
• Incurable deterioration means the cost of fixing the problem
exceeds the value added. A simple way used to estimate this
depreciation is to base it on the effective age of the property
relative to its economic life, the ratio is applied to the value that
deducts the curable depreciation
 Cost Approach
Ø Functional obsolescence is a loss in value due to a design that is not
appropriate for the intended use of the property
• Usually results in less rent income or higher operating expenses
• The amount of functional obsolescence is estimated by the
present value of the income loss
Ø Locational obsolescence results when the location is not optimal for
the property
Ø Economic obsolescence results when new construction is not feasible
under current economic conditions
 Cost Approach - Example
Market value of the land (from comparables) $4,000,000

Replacement cost, including constructor’s profit $16,750,000

Reduction for curable deterioration ($1,000,000)

Reduction for incurable deterioration (total economic life and effective ($3,150,000)
age is 50 and 10 respectively, so ratio of effective to total is 20%

Reduction for functional obsolescence (poor floor plan and ($1,750,000 )

substandard energy efficiency)
Reduction for locational obsolescence (recent construction of roads in ($1,000,000 )
park land thus reducing amenity)
Reduction for economic obsolescence (recent construction of ($1,000,000)
competing properties thus increasing supply and vacancy rates)
Final appraised value (building and land) $12,850,000
 Sales Comparison Approach
Steps involved with applying the sales comparison approach:
1. Adjust the prices of similar (comparable) properties for size, age, location,
property condition, and market conditions at the time of sale, etc.
2. Calculate the per-square-price according to each adjusted price
3. Calculate the average of all the per-square-prices
• More weight may be given to comparables that are more similar to the
subject property
4. Multiply the average per-square-price by the size of the subject property to
obtain the estimated value
 Sales Comparison Approach - Example
Subject comparables
variable
property 1 2 3 4 5
Size(square
15,000 25,000 20,000 10,000 16,000 12,500
feet
Age (years) 10 1 5 10 15 20
Condition Average Good Good Good Average Poor
Location Prime Prime Secondary Secondary Secondary Prime
Date of sale
(months 3 9 6 7 12
ago)
$5,500,0 $3,000,00 $1,300,00
Sale price $1,300,000 $1,750,000
00 0 0
Sale price
$220 $150 $130 $109 $104
psf
 Sales Comparison Approach - Example
The following indicates how the adjustments were made to the comparables to
reflect the characteristics of the subject property:
1. Depreciated at 2.5 percent per annum.
2. Condition adjustment after average depreciation is taken into account: Good,
none; Average, 10%; Poor, 20%.
3. Location adjustment: Prime, none; Secondary, 20%.
4. Market has been rising by 0.5 percent per month.
 Sales Comparison Approach - Solution
Subject comparables
variable
property 1 2 3 4 5
Age (years) 10 -22.5% -12.5% 0 12.5% 25%
Condition Average -10% -10% -10% 0 10%
Location Prime 0 20% 20% 20% 0
Date of sale
1.5% 4.5% 3% 3.5% 6%
(months ago)
Adjusted
$151.8 $153 $146.9 $148.24 $146.64
price psf
Average
$149.3
price psf
Appraised
$2,239,500
value
Summary
Ø Importance: ☆☆☆
Ø Content:
• The cost approach
• The sales comparison approach
Ø Exam tips:
• 必须掌握不动产估值的成本法和交易比较法
 Real Estate Indices and Debt
Tasks:
Ø Describe due diligence in private equity real estate investment
Ø Discuss private equity real estate investment indices
Ø Calculate and interpret financial ratios used to analyze and evaluate
private real estate investments
 Due Diligence
Ø Investors perform due diligence to confirm the facts and conditions that
might affect the value of the transaction.
Ø Due diligence involves: reviewing leases, confirming expenses, performing
inspections, surveying the property, examining legal documents, and
verifying compliance.
 Real Estate Indices
Ø Appraisal-Based Indices rely on appraisals to estimate how the value of a
portfolio of properties is changing over time
Ø Transaction-Based Indices are created based on actual transactions
• Repeat sales index replies on repeat sales of the same property
• Hedonic index requires only one sale, includes variables in a
regression that control for differences in size, age, quality of
construction, location, etc.
Ø Appraisal-based indices tend to lag transaction-based indices and tend to
underestimate volatility and correlation with other asset classes.
 Private Market Real Estate Debt
Ø The maximum amount of debt that an investor can obtain on commercial real
estate is usually limited by either the ratio of the loan to the appraised value
of the property (loan to value or LTV) or the debt service coverage ratio
(DSCR), depending on which measure results in the lowest loan amount.

Debt service coverage ratio

DSCR = (first-year NOI) / debt service

Loan-to-value ratio

LTV = (loan amount) / (appraisal value)

 Private Market Real Estate Debt
Example

A property has been appraised for $5 million and is expected to have NOI of
$400,000 in the first year. The lender is willing to make an interest-only loan
at an 8 percent interest rate as long as the loan-to-value ratio does not
exceed 80 percent and the DSCR is at least 1.25. The balance of the loan will
be due after seven years. How much of a loan can be obtained?
 Private Market Real Estate Debt
Solution
Based on the loan-to-value ratio, the loan would be 80 percent of $5 million or
$4 million.
With a DSCR of 1.25, the maximum debt service would be $400,000/1.25 =
$320,000. If the loan is interest only, then we can obtain the loan amount by
simply dividing the mortgage payment by the interest rate: $320,000/0.08 =
$4,000,000.
In this case, we obtain the same loan amount based on either the LTV or DSCR
requirements of the lender. If one ratio had resulted in a lower loan amount,
that would normally be the maximum that could be borrowed.
Summary
Ø Importance: ☆☆
Ø Content:
• Due diligence
• Private real estate indices
• Private real estate debts
Ø Exam tips:
• 了解私人不动产投资的尽职调查
• 了解私人不动产投资指数
• 掌握私人不动产负债财务分析比值和最低贷款额计算
Characteristics of Publicly Traded Real
Estate Securities
Tasks:
Ø Describe types of publicly traded real estate securities
Ø Explain advantages and disadvantages of investing in real estate through
publicly traded securities
 Basic Forms of Real Estate Investments
Ø Real Estate Investment Trusts (REITs) are tax-advantaged entities that
typically own, operate, and to a limited extent develop income-producing
real estate property. They include equity REITs and mortgage REITs
Ø Real Estate Operating Companies (REOCs) are ordinary taxable real estate
ownership companies. They are located in countries that do not have a tax-
advantaged REIT regime or when they engage to a large extent in the
development of real estate, often with the intent to sell
Ø Mortgage-Backed Securities (MBS) are asset-backed securitized debt
obligations. They include commercial MBS and residential MBS
 Advantages of Publicly Traded Real Estate Investments
Ø Superior liquidity.
Ø Lower minimum investment.
Ø Limited liability.
Ø Access to premium properties.
Ø Active professional management.
Ø Protections accorded to publicly traded securities.
Ø Greater potential for diversification.
Ø Exemption from taxation.
Ø Earnings predictability.
Ø High yield.
 Disadvantages of Publicly Traded Real Estate Investments
Ø Taxes versus direct ownership.
Ø Lack of control.
Ø Costs of a publicly traded corporate structure.
Ø Price is determined by the stock market.
Ø Structural conflicts of interest.
Ø Limited potential for income growth.
Ø Forced equity issuance.
Ø Lack of flexibility.
Summary
Ø Importance: ☆☆
Ø Content:
• Types of publicly traded real estate securities
• Advantages and disadvantages of publicly traded real estate securities
Ø Exam tips:
• 了解公开交易的不动产证券类型
• 了解公开交易的不动产证券的优缺点
 Real Estate Investment Trust (REIT)
Tasks:
Ø Explain economic value determinant, investment characteristics, principal
risks, and due diligence considerations for real estate investment trust
shares
Ø Describe types of REITs
 Publicly Traded Equity REITs
REIT Structure
Ø Simple structure that hold and operate properties directly.
Ø Umbrella partnership REITs (UPREITs) under which the REIT has a
controlling interest in and serves as the general partner that owns and
operates all or most of the properties.
Ø DOWNREIT is a variation of the UPREIT under which the REIT owns
more than one partnership and may own properties at both the REIT
level and the partnership level.
 Publicly Traded Equity REITs
Investment Characteristics

Ø Exemption from corporate-level income taxes.

Ø High dividend yield.

Ø Low income volatility.

Ø Frequent secondary equity offerings.

 Publicly Traded Equity REITs
Due Diligence
Ø Remaining lease terms.
Ø Inflation protection.
Ø Occupancy rates and leasing activity.
Ø In-place rents versus market rents.
Ø Costs to re-lease space.
Ø Tenant concentration in the portfolio.
Ø Tenants’ financial health.
Ø New supply versus demand.
Ø Balance sheet analysis.
Ø Quality of management.
 Types of REITs
Retail REITs
Ø Invest in such retail properties as regional shopping malls, community
shopping centers, or premium retail space
Ø Lease terms are typically 3-10 years
Ø Tenants pay a net rent, plus a share of the common area costs based on
their proportionate share of the space leased
Office REITs
Ø Invest in and manage multi-tenanted office properties
Ø Lease terms are typically long (5-25 years)
Ø With contractual base rents that are fixed and adjust upward
Ø Tenants also pay their proportionate share of operating expenses, common
area costs, and property taxes
 Types of REITs
Residential ("multi-family") REITs
Ø Invest in and manage rental apartments, typically using one-year leases
Ø Tenants typically pay gross leases
Health care REITs
Ø Invest in skilled nursing facilities, assisted living and independent residential
facilities for retired persons, hospitals, medical buildings, and rehabilitation
centers
Ø REITs are typically not permitted to operate these facilities themselves
Ø Leases are typically net leases
 Types of REITs
Industrial REITs
Ø own properties used in manufacturing, warehousing and distribution
Ø Lease terms are typically 5-25 years
Hotel REITs
Ø Own hotel properties, but usually not permitted to operate the
properties themselves
Ø Rental income typically accounts for the major portion of a hotel’s
net operating cash flow
Ø The hotel sector is cyclical and not protected by long-term leases .
 Types of REITs
Storage REITs
Ø Own and operate self-storage lockers to individuals and small
businesses.
Ø Tenants typically pay gross leases, usually on a monthly basis
Diversified REITs
Ø Own and operate in multiple types of real estate.
 Types of REITs
Risk Factors
Ø Significant mismatches between supply and demand (particularly
health care, hotel, and office REITs
Ø Varying occupancy rates over a short period of time (especially hotels)
Ø Quality and locations of properties held by REITs
Ø Financing status of REITs
 Types of REITs
Importance of Factors affecting Economic Value for Properties

National New Space

Retail Sales Population
GDP Job Creation supply vs.
Growth Growth
Growth Demand
Retail 1 3 2 4 4
Office 1 2 5 4 3
Industrial 1 5 2 3 4
Multi-family 1 2 5 2 4
Storage 1 3 5 2 4
Health care 1 4 5 2 3
Hotels 1 2 5 4 3

Note: 1 = most important, 5 = least important

Summary
Ø Importance: ☆
Ø Content:
• Characteristics of REITs
• Due diligence of REITs
• Types of REITs
Ø Exam tips:
• 了解不动产投资信托基金的特征，尽职调查，和类型
 Net Asset Value Per Share (NAVPS)
Tasks:
Ø Justify the use of net asset value per share in REIT valuation
Ø Estimate NAVPS based on forecasted cash net operating income
 Valuation – Net Asset Value Approach
Ø NAVPS is the difference between a real estate company’s assets and
liabilities, all taken at current market values, divided by the number of
shares outstanding
Ø Discounts in the REIT share price from NAVPS indicate potential
undervaluation
Ø Premiums in the REIT share price to NAVPS, in the absence of positive
future events such as successful property developments or expected
high value creation by a management team, suggest potential
overvaluation
 Valuation – Net Asset Value Approach
Steps in NAVPS Approach
1. Values of properties held by REITs and REOCs are estimated by capitalizing
the rental streams (NOI) using a cap rate
Ø NOI removes non-cash rents due to accounting practice of “straight
lining” the rental revenue from lone-term leases
Ø NOI is also increased to reflect a full year’s rent for properties acquired
during the course of the year
Ø NOI is then increased to include expected growth
 Valuation – Net Asset Value Approach
2. The book values of other tangible assets including cash, account receivable,
land for future development, prepaid expenses are added to obtain
estimated gross asset value
Ø Goodwill and deferred tax assets are excluded
2. Debt and other liabilities are subtracted to obtain net asset value
Ø Deferred tax liabilities are excluded
2. Division by the number of shares outstanding produces NAVPS
 Valuation – Net Asset Value Approach
Estimated cash NOI
÷ Assumed cap rate
= Estimated value of operating real estate
+ other assets (Cash and receivable, land, etc.) excluding goodwill and
deferred tax assets
－Debt and other liabilities excluding deferred tax liabilities
= Net asset value
÷ Shares outstanding
= NAV/share
Net Asset Value Approach - Example
Last 12-months real estate NOI $270,432
Less: Non-cash rents - $7,667
Plus: Adjustment for full impact of acquisitions (1) + $4,534
Pro forma cash NOI for last 12 months = $267,299
Plus: Next 12 months growth in NOI (2) + $4,009
Estimated next 12 months cash NOI = $271,308
Assumed cap rate (3) 7.00%
Estimated value of operating real estate = $3,875,829
Plus: Cash and equivalents + $65,554
Plus: Land held for future development + $34,566
Plus: Accounts receivable + $45,667
Plus: Prepaid/Other assets (4) + $23,456
Estimated gross asset value = $4,045,072
 Net Asset Value Approach - Example
Less: Total debt - $1,010,988
Less: Other liabilities - $119,886
Net asset value = $2,914,198
Shares outstanding 55,689
NAVPS = $52.33

(1) 50 percent of the expected return on acquisitions was made in the middle of
2010.
(2) Growth is estimated at 1.5 percent.
(3) Cap rate is based on recent comparable transactions in the property market.
(4) This figure does not include intangible assets.
 Valuation – Net Asset Value Approach
Considerations in NAV approach
Ø The discount rate used by a private owner could be different from the
discount rate used by REIT investors
Ø NAV reflects the value of a REIT’s assets to a private market buyer
Ø NAV implicitly treats the REIT as a static pool of assets (sum-of-the-parts)
Ø NAV estimates can become quite subjective when property market become
illiquid and when REITs own hundreds of properties
Summary
Ø Importance: ☆☆☆
Ø Content:
• NAVPS valuation
• Considerations in NAVPS approach
Ø Exam tips:
• 必须掌握NAVPS计算
• 了解NAVPS的缺点
 Fund From Operation (FFO)
Adjusted Fund From Operation (AFFO)
Tasks:
Ø Describe the use of funds from operations and adjusted fund from
operation in REIT valuation
Ø Calculate the value of a REIT share using price-to-FFO and price-to-AFFO
Valuation – Relative Value (price multiple) Approach
Ø P/FFO and P/AFFO multiples are used in relative valuation
Ø Formula for FFO (funds from operations)

Accounting net earnings

+ Depreciation expense

+ Deferred tax expenses

- Gains from sales of property and debt restructuring

= Funds from operations

 Valuation – Relative Value (price multiple) Approach
Ø Formula for AFFO (adjusted funds from operations)

FFO (funds from operations)

－ Non-cash (straight-line) rent adjustment

－ Recurring maintenance-type capital expenditures and leasing

commissions

= AFFO (adjusted funds from operations)

 Valuation – Relative Value (price multiple) Approach
Example
Patricia Ly, CFA finds the following data for a particular industrial REIT:
Net operating income (NOI): $710,000
Funds from operations (FFO): $630,000
Assumed cap rate: 6%
Shares outstanding: 90,000 shares
Storage property average P/FFO multiple: 13x.
Industrial property average P/FFO multiple: 10x.
Ly decides to perform a valuation on this REIT. The value per share of this REIT
using a price-to-FFO approach is closest to:
Valuation – Relative Value (price multiple) Approach
Solution

FFO/share = FFO / Shares outstanding = $630,000/90,000

= $7/share.

The relevant subsector average P/FFO multiple is the value for industrial
properties of 10x

FFO/share x P/FFO multiple = $7.00 x 10x = $70.00

Summary
Ø Importance: ☆☆☆
Ø Content:
• FFO and AFFO
Ø Exam tips:
• 必须掌握FFO和AFFO计算
• 使用P/FFO和P/AFFO估值
Fundamentals of Private Equity Investments
Tasks:
Ø Explain sources of value creation in private equity
Ø Explain how private equity firms align their interests with those of the
managers of portfolio companies
Ø Distinguish between the characteristics of buyout and venture capital
investments
 Sources of Value Creation in Private Equity
Ø Reengineer firm for more efficient operations – bring expertise
Ø Obtain lower cost debt financing via access to cheap credit and few
covenants
Ø Parallel goal alignment between management and private equity owners
 Alignment of Economic Interests
Ø Managers focus on long term performance over short term

Ø Mechanisms to align interests of private equity firm and managers specified

in term sheet

Ø Examples of control mechanisms specified in term sheet:

• Compensation – closely linked to performance and promote goal
achievement
• Tag Along Clause – management has right to buy equity position if PE
firm sells it stake
Valuation Characteristics of Venture Capital Investments
Ø Cash flow – unpredictable
• Product – uncertain future based on new technology

Ø Asset base is weak

Ø Management team has strong entrepreneurial record

Ø Low leverage, mostly equity

Ø Risk assessment is difficult to measure

Valuation Characteristics of Venture Capital Investments
Ø Exit strategy is unpredictable (IPO or firm sale)
Ø Operations – High cash burn rate
Ø Capital required in growth phase
Ø Returns from few highly successful investments with write-offs from many
failures
Ø Not active in public capital markets
Ø Future funding – less scalable
Ø Carried interest most common, no transaction and monitoring fees
Valuation Characteristics of Buyout Investments
Ø Cash flow – stable and predictable

Ø Established products

Ø Substantial asset base

Ø Experienced management team

Ø Highly levered with senior debt

Ø Risk can assessed from mature operations

Valuation Characteristics of Buyout Investments
Ø Exit strategy is predictable

Ø Reduction in operational inefficiencies

Ø Low working capital requirements

Ø Low variability in success, rare failures

Ø Active in public capital markets

Ø Subsequent funding easy with strong performance

Ø Carried interest, transaction, and monitoring fees

Summary
Ø Importance: ☆
Ø Content:
• Sources of value creation in PE
• Alignment of interest
• Valuation characteristics of VC and Buyouts
Ø Exam tips:
• 了解PE价值创造来源
• 了解PE与组合公司管理层利益联盟
• 了解VC和Buyout估值特征
Components of Performance from LBO
Exit Routes
Tasks:
Ø Describe valuation issues in buyout and venture capital transactions
Ø Explain alternative exit routes in PE and their impact on value
Valuation Issues in Private Equity
Valuation issue Buyout Venture capital

Use of DCF Frequently used Uncertain cash flows

Relative value Validates DCF No comparables

Use of debt High Low, more equity

EPS growth, P/E Pre-money valuation,

Key return drivers
expansion, debt reduction future dilution
Components of Performance from a Leveraged Buyout
Ø Exit Value = Investment Cost + Earnings Growth + Multiple Expansion +
Reduction in Debt

Ø Not valuation but max price determination to pay upfront and forecasted
exit value

Ø Earnings growth due to operational efficiencies

Ø Increase in price multiple due to increased growth

Ø Apply scenario analysis to forecasts

 Components of Performance from a Leveraged Buyout
Example:
Suppose there is a €5,000 (amounts in millions) investment in a PE transaction.
The transaction is financed with 50 percent debt and 50 percent equity. The
€2,500 equity investment is further broken into €2,400 of preference shares
owned by the PE fund, €95 of equity owned by the PE fund, and €5 of
management equity. The preference shares are promised a 12 percent annual
return (paid at exit). The PE firm equity is promised 95 percent of the residual
value of the firm after creditors and preference shares are paid, and
management equity holders are promised the remaining 5 percent. Assume that
the exit value, five years after investment, is 1.6 times the original cost. The
initial investment of €5,000 has an exit value of €8,000. what are the specific
payoffs for the four claimants?
 Components of Performance from a Leveraged Buyout
Solution:
Ø Senior debt has been partially retired with operational cash flows, reducing
debt from €2,500 to €1,600. So debtholders get €1,600.
Ø Preference shares are paid a 12 percent return for 5 years, so they receive
€2,400(1.12)^5 = €4,230.
Ø PE Fund equity receives 95 percent of the terminal equity value, or 0.95[8000
− (4230 + 1600)] = €2,061.
Ø Management equity receives 5 percent of the terminal equity value, or
0.05[8000 − (4230 + 1600)] = €109.
 Exit Routes and PE Value
1) Initial Public Offering (IPO):

Ø Pros: highest exit value, higher liquidity, access to capital, and attract
good management

Ø Cons: Less flexible, more costly, and complex

Ø When to use: Strong growth prospects, operating history, size

Ø Timing is key!
 Exit Routes and PE Value
2) Secondary Market sale: sale from one firm to another for strategic reasons
• Pros: second highest valuation

3) Management Buyout: firm sold to management with significant use of

leverage

4) Liquidation: Outright sale of firm’s assets, firm no longer viable

• Con: Lowest valuation, negative public perception
Summary
Ø Importance: ☆☆
Ø Content:
• Valuation issues in PE
• Components of performance from LBO
• Exit routes
Ø Exam tips:
• 重点掌握LBO的投资业绩组成
• 了解PE退出策略
 Risks, Costs and other details of PE investing
Tasks:
Ø Explain private equity fund structures, terms, valuation, and due diligence
in the context of an analysis of private equity fund returns
Ø Explain risks and costs of investing in private equity
 Risks in Private Equity Investing
Ø Liquidity risk – not publicly traded
Ø Competition environment risk – fewer deals with good prospects at low cost
Ø Agency risk – principal agent conflict
Ø Capital risk – withdrawal of capital due increase in business and financial
risk
Ø Regulatory risk – adverse government regulation
Ø Tax risk – treatment of returns changes
Ø Valuation risk – reflects subjective judgement
Ø Diversification risk – poorly diversified across stage, vintage, and strategy
Ø Market risk – long term factors such as interest rates and exchange rates
 Costs of Private Equity Investing
Ø Transaction costs – due diligence, bank financing, legal fees
Ø Fund set up costs – usually amortized over life of fund
Ø Administrative costs – custodian, transfer agent, and accounting costs
charged yearly
Ø Audit fees
Ø Management fee = 2% (typical)
Ø Performance fee = 20% (typical)
Ø Dilution costs – resulting from additional rounds of financing and stock
options
Ø Placement fees – as much as a 2% up-front fee or annual trailer paid to
placement agents
 Private Equity Details
Ø Structure – limited partnership (LP) provides funding, no active role, limited
liability. GP liable for all debts and unlimited liability, 10-12 year lives.
Ø Economic Terms – “qualified” investors only with > $1.0 mm in assets
• Management fees – 1.5%-2.0%
• Carried interest – GP’s share of profits
• Ratchet – allocation of equity between shareholders and fund management
 Private Equity Details
• Hurdle rate – IRR target before GP can receive carried interest (7%-10%)
• Target fund size – Signals GP’s ability to raise funds, below is negative signal
• Vintage – year fund was started
 Private Equity Details
Ø Corporate Governance Terms:
• Key man clause – in case of the departure of key named executives or
insufficient time spent in management of the fund, the GP may be
prohibited from making any new investments until a new executive is
appointed
• Disclosure and confidentiality
• Clawback provision requires the GP to return capital to LPs in excess of the
agreed profit split between the GP and LPs
 Private Equity Details
Ø Distribution waterfall is a mechanism providing an order of distributions to
LPs first before the GP receives carried interest
• Deal-by-deal waterfalls allow earlier distribution of carried interest to
the GP
• Total return waterfalls allow earlier distributions to LPs
ü The GP receives carried interest only after the fund has returned
the entire committed capital to LPs
ü The GP receives carried interest on any distribution as long as the
value of the portfolio exceeds a certain threshold above invested
capital
 Private Equity Details
Ø Tag-along, drag along rights: any potential acquirer of the company may not
acquire control without extending an acquisition offer to all shareholders,
including the management
Ø No-fault divorce: a GP may be removed without cause provided that a super
majority of LPs approve
Ø Removal for “cause”: allows either a removal of the GP or an earlier
termination of the fund for cause
Ø Investment restrictions
Ø Co-investment
Summary
Ø Importance: ☆☆
Ø Content:
• Risks and costs of PE investing
• Structures, terms and governance of PE
Ø Exam tips:
• 理解PE投资的风险和成本
• 熟悉PE投资的结构，术语和治理条款
 Financial Performance of PE Funds
Tasks:
Ø Interpret and Compare financial performance of PE funds from the
perspective of an investor
Ø Calculate management fees, carried interest, net asset value, distributed
to paid in (DPI), residual value to paid in (RVPI), and total value to paid in
(TVPI) of a PE fund
 Financial Performance of Private Equity Funds
Ø Recommended: GIPS Since inception IRR

• SI-IRR is a money weighted return

• Assumes intermediate cash flows reinvested at IRR but PE funds tend to be

illiquid

• Gross or net of fees

• Considers time value of money

 Financial Performance of Private Equity Funds
Ø Multiples: Popular, simple, easy to use and differentiates between realized
and unrealized returns, specified by GIPS

• Paid in Capital (PIC) – % of capital used by GP

• Distributed to PIC (DPI) – measures LP realized return, cash on cash return

• Residual Value to PIC (RVPI) – measures LP’s unrealized return

• Total value to PIC – measures LP’s realized and unrealized return, sum of DPI,
and RVPI
 Financial Performance of Private Equity Funds
Example:

The GP for PE Fund charges a management fee of 2% and carried interest of 20%,
which is paid after portfolio value exceeds committed capital

The total committed capital for the fund was $180 million

Calculate management fees, carried interest, NAV before and after distributions,
DPI, RVPI, and TVPI
 Financial Performance of Private Equity Funds
Solution:

Management Fee = 2% × Paid in Capital

Year Paid in capital Management fee

2007 150 3
2008 160 3.2
 Financial Performance of Private Equity Funds
Ø Calculate Carried Interest = 20% × (NAV before distributions - committed
capital)
Ø Calculate carried interest
• Committed capital = $180
• NAV before distributions = $94.2 in 2006, $181.2 in 2007, and $227.8 in
2008

Ø In 2007, carried interest is 20% × (NAV before distribution – Committed

Capital) = 20% × ($181.2 – $180) = $0.24
Ø In 2008, carried interest is 20% × change in NAV before distribution = 20% ×
($227.8 – $181.2) = $9.32
 Financial Performance of Private Equity Funds
NAV before distributions = previous year NAV after distribution + capital called
down – management fee + operating results

Ø Calculate 2008 NAV before distribution

• 2007 NAV after distribution = $141.0

• 2008 capital called down = $10.0

• 2008 management fee = $3.2

• Operating results = $80.0

Ø 2008 NAV before distributions = $141.0 + $10.0 – $3.2 + $80.0 = $227.8

 Financial Performance of Private Equity Funds
NAV after distributions = NAV before distribution – carried interest -
distribution

Ø Calculate 2008 NAV after distributions:

• 2008 NAV before distributions = $227.8

• 2008 Carried interest = $9.32

• 2008 Distributions = $60

Ø 2008 NAV after distributions = $227.8 – $9.3 – $60 = $158.5

 Financial Performance of Private Equity Funds
Distributed to PIC (DPI) measures GP realized return or cash on cash return
DPI = Cumulative Distributions / Paid-in-Capital
• Distributions in 2007 = $40,
• 2008 = $60
• 2009 = $100
• Assume 2009 paid-in-capital was $165

2009 Distributed PIC = ($40 + $60 + $100) / $165 = 1.21

 Financial Performance of Private Equity Funds
Residual Value to PIC (RVPI) – measures LP’s unrealized return

RVPI = NAV after Distributions / Paid-in-Capital

Assume:
• 2009 NAV after distributions = $177.7
• 2009 paid in capital = $165

2009 Residual Value to PIC = $177.7 / $165 = 1.08

 Financial Performance of Private Equity Funds
Total value to PIC (TVPI) – measures LP’s realized (DPI) and unrealized (RVPI)
returns

TVPI = DPI + RVPI

Assume:
• 2009 DPI = 1.21
• 2009 RVPI = 1.08

2009 Total Value to PIC = 1.21 + 1.08 = 2.29

Summary
Ø Importance: ☆☆☆
Ø Content:
• Financial performance of PE funds
Ø Exam tips:
• 必须掌握PE基金投资业绩的相关计算（management fees, carried
interest, NAV, DPI, RVPI, TVPI）
 VC Valuation
Tasks:
Ø Calculate pre-money valuation, post-money valuation, ownership fraction,
and price per share applying the venture capital method 1) with single and
multiple financing rounds and 2) in terms of IRR
Ø Demonstrate alternative methods to account for risk in venture capital
 The Venture Capital Method and a Single Financing Round
Example:
Ø A firm’s entrepreneurs believe they can sell the firm for $60 mm (FV) in 5
years
Ø Initial investment $7 mm (INV)
Ø They want to hold 1 mm shares
Ø Discount rate of 40%

Ø Calculate pre- and post-money valuation, ownership fraction and price per
share in IRR terms
 The Venture Capital Method and a Single Financing Round
Post-Money Valuation:
FV
POST 
(1  r ) N
60, 000, 000
POST  5
 $11,156, 066
(1  0.40)
Pre-Money Valuation:
PRE = POST －INV

PRE = 11,156,066 －7,000,000 = $4,156,066

The Venture Capital Method and a Single Financing Round
Required Fractional Ownership (ƒ):
INV
f 
POST

7, 000, 000
f   62.75%
11,156, 066

Shares required for PE firm

f
Spe  Se[ ]
(1- f )
0.6275
Spe  1,000,000[ ]  1,684,564
(1- 0.6275)
The Venture Capital Method and a Single Financing Round
Stock Price per share:
INV
P
Spe
7,000,000
P  $4.16 per share
1,684,564
 The Venture Capital Method and Multiple Financing Round
Example:

Ø Entrepreneurs need $4 million now and $3 million in three years

Ø IPO firm for $60 million in 5 years, want 1 million shares, and
discount rate is 40%

Ø Calculate pre- and post-money valuation, ownership fraction and

price per share in IRR terms
The Venture Capital Method and Multiple Financing Round
Compound Discount Rate:

r1  (1.40)(1.40)(1.40) -1  174.40%
r2  (1.40)(1.40) -1  96%

Post-Money Valuation at 2nd financing round:

FV
POST2 
(1  r2 )
60, 000, 000
POST2   $300, 612, 245
(1  0.9600)
The Venture Capital Method and Multiple Financing Round
Pre-Money Valuation at 2nd financing round

PRE 2  POST2 - INV2

PRE 2  30,612,245- 3,000,000  $27,612,245

Post-Money Valuation at 1st financing round:

PRE2
POST1 
(1  r1 )
$27, 612, 245
POST1   $10, 062, 771
(1  1.7440)
 The Venture Capital Method and Multiple Financing Round
Pre-Money Valuation at 1st financing round

PRE1  POST1 - INV1

PRE1  10,062,771- 4,000,000  $6,062,771
Required ownership for 2nd round investors:
INV2
f2 
POST 2
3,000,000
f2   9.80%
30,612,245
 The Venture Capital Method and Multiple Financing Round
Required ownership for 1st round investors:

INV1
f1 
POST 1
4,000,000
f1   39.75%
10,062,771
Required shares for 1st round investors:
f
Spe1  Se[ ]
(1- f )
0.3975
Spe1  1,000,000[ ]  659,751
(1- 0.3975)
 The Venture Capital Method and Multiple Financing Round
Stock price after 1st financing round:

INV
P1 
Spe1
4,000,000
P1   $6.06
659,751
Required shares for 2nd round investors:

f2
Spe2  ( Se  Spe1 )[ ]
(1- f2 )
0.098
Spe2  (1,000,000  659,751)[ ]  180,382
(1- 0.098)
 The Venture Capital Method and Multiple Financing Round

Stock price after 2nd financing round:

INV2
P2 
Spe2
3,000,000
P2   $16.64
180,328
The VC Method, a Single Financing Round, and the IRR
Example:

Ø In the previous example, we used a NPV approach

Ø Now we use the IRR approach with a single financing round

Ø The firm will still sell for $60 million in 5 years, need $7 million now, 1 million
shares for entrepreneurs & disc. Rate 40%

Ø Calculate valuation statistics for PE firm

 The VC Method, a Single Financing Round, and the IRR

Investor’s Future Wealth (W):

W  INV ´ (1 r ) N
W  7,000,000 ´ (1 0.40)5
 $37,647,680
Required Fractional Ownership for the PE firm:

W
f
FV
37,647,680
f  62.75%
60,000,000
 The VC Method, a Single Financing Round, and the IRR
Shares required for PE firm:
f
Spe  Se[ ]
(1- f )
0.6275
Spe  1,000,000[ ]  1,684,564
(1- 0.6275)
Stock Price per share:

INV
P
Spe
7,000,000
P  $4.16 per share
1,684,564
The VC Method, a Single Financing Round, and the IRR
Post-Money Valuation:
POST  P ´ ( Spe  Se )
POST  4.16 ´ (1,684,564 1,000,000)
 $11.1 million

Pre-Money Valuation:
PRE = POST －INV

PRE = 11.1 million －7.0 million = $4.1 million

The VC Method, a Single Financing Round, and the IRR

Example:

Ø Assume the possible terminal values are $60 million, $40 million and $0

Ø If each has an equal probability of occurring, then the expected terminal

1 1 1
value is:  ($60)  ($40)  ($0)  $33.3 million
3 3 3
Summary
Ø Importance: ☆☆☆
Ø Content:
• VC valuations
Ø Exam tips:
• 必须掌握VC投资的估值计算（pre-money, post-money,
ownership fraction, price per share）
 Fundamentals of Commodities
Tasks:
Ø Compare characteristics of commodity sectors
Ø Compare the life cycle of commodity sectors from production through
trading or consumption
Ø Contrast the valuation of commodities with the valuation of equities and
bonds
Ø Describe types of participants in commodity futures markets
 Characteristics of Commodity Sectors
Energy:
Ø Crude oil
• has limited use by itself
• drivers of demand and supply include technology, politics, and business
cycle
Ø Natural gas
• can be used directly
• storage and transportation costs are relatively high
• drivers of demand and supply are similar to crude oil, but also include
weather
Ø Refined products (heating oil, gasoline, jet fuel, propane, etc)
• typically has a short shelf life
 Characteristics of Commodity Sectors
Ø Grains
• generally have long storage period to last multiple seasons
• weather is extremely important
Ø Industrial metals (copper, aluminum, etc)
• demand is associated directly with GDP growth
• can be stored for years, less susceptible to weather
• politics have a sizable impact on pricing
Ø Livestock
• drivers of supply include grain prices, weather, disease, government-
permitted use of drugs and growth hormones
• GDP per capita is the most important driver of demand
• this sector is becoming more global (cross-border M&A)
 Characteristics of Commodity Sectors
Ø Precious metals (gold, silver, platinum, etc)
• both as stores of value (similar to currencies) and consumed inputs in
electronics, auto parts, jewelry, etc)
• drivers of supply and demand include inflation expectations, fund flows,
industrial production, etc.
Ø Softs/cash crops (cotton, coffee, sugar, cocoa, etc)
• sold for income as opposed to consumed for subsistence
• storability is important
• weather is an important driver of supply
• demand is related to global wealth
 Life Cycle of Commodity Sectors
Ø life cycle means the time span from production through trade and
consumption

Ø a short life cycle allows for rapid adjustment to outside events

Energy

• natrual gas can be consumed nearly after extraction

• crude oil has to be transformed into refined products which have a number
of potential processing steps depending on the quality of crude oil input
 Life Cycle of Commodity Sectors
Industrial/Precious Metals
• a key consideration regarding the supply is economics of scale
• given typical economic cycle and time lag involved between deciding to
expand capacity, new supply often arrives just as demand is declining
Livestock
• advances in freezing technologies have increased the import/export trade
• Grains
• demand is year round but growing cycle is less than one year
 Valuation of Commodities
Compared to equities and bonds, commodities

Ø are tangible/physical assets with an intrinsic economic value

Ø do not generate future cash flows beyond what can be realized through
purchase and sale

Ø the valuation is not based on future profitability and cash flows but on future
possible prices which are based on demand and supply

Ø incur transportation and storage costs which affect the shape of the forward
price curve
 Participants in Commodity Futures Markets
Ø Hedgers trade in the markets to hedge their exposure related to the
commodity
• hedgers may speculate based on their perceived unique insight into
market conditions and determine the appropriate amount of hedging
Ø Traders and investors (speculators) speculate on market direction or
volatility and provide liquidity and price discovery for the market in exchange
for a profit
Ø Arbitrageurs attempt to capitalize on mispricing between commodity (along
with related storage and financing costs) versus the future price
 Participants in Commodity Futures Markets
Ø Exchanges (clearing houses) set trading rules and provide the
infrastructure of transmitting prices and payments
Ø Analysts use the exchange information for non-trading purposes, such as
creating products based on commodity futures (ETF)
Ø Regulators monitor the market
Summary
Ø Importance: ☆
Ø Content:
• Characteristics of commodity sectors
• Life cycles of commodities
• Valuation comparison of commodities and traditional investments
• Types of participants
Ø Exam tips:
• 了解大宗商品分类，生命周期，与传统资产估值比较，及参与者类型
 Contango and Backwardation
Theories of commodity Futures Returns
Tasks:
Ø Analyze the relationship between spot prices and expected future prices in
markets in contango and markets in backwardation
Ø Compare theories of commodity futures returns
 Spot and Futures Pricing
Ø Basis is the difference between spot and futures prices
Ø Backwardation is the situation in which spot price exceeds the futures
price, or the near-term (closer to expiration) futures price is higher than
the longer-term futures price (positive calendar spread)
Ø the opposite case of backwardation is contango
Ø the futures price difference between the near-term and longer-term
contract is the calendar spread
Spot and Futures Pricing
Ø commodity futures are settled by either cash or physical delivery
Ø cash settlement enable higher involvement of speculators and
arbitrageurs
Ø physical settlement ensures a convergence of the futures and spot
price, which may not occur in a cash-settlement market
Ø spot prices are highly localized and associated with physical delivery,
limiting the ability to hedge and speculate
Ø futures prices can be global
 Theories of Futures Returns
Insurance Theory (normal backwardation)
Ø a commodity producer is long the physical good and thus would
short futures contracts to hedge its sales price and make their
revenues more predictable
Ø the futures curve is in backwardation normally because
producers persistently sell futures, pushing down futures prices
Ø the futures price has to be lower than the current spot price as a
form of remuneration to speculators who takes on the price risk
Ø this theory does not explain contango
 Theories of Futures Returns
Hedging Pressure Hypothesis
Ø hedging pressure occurs for both producers and consumers
Ø if the two forces of producers and consumers are equal in weight,
then the futures curve is flat
Ø if producers are more interested in selling futures than consumers,
the market is backwardation in order to attract speculators to
complete the market
Ø if consumers are more concerned about price risk, the market is
contango
Ø the theory is still incomplete
• producers generally have greater exposure to price risk than
consumer do
• both producers and consumers speculate on commodity prices
 Theories of Futures Returns
Theory of Storage
Ø storage costs lead to a higher price in the future (contango)
Ø convenience yield lead to a lower price in the future (backwardation)
Ø holding commodities inventory provides a benefit to consumers
because it acts as a buffer to a potential supply disruption
Ø convenience yield is inversely related to the inventory size and
availability of commodities
futures price = spot price + storage costs - convenience yield
Ø all theories have components that are unobservable and volatile,
therefore not reliably calculable
Summary
Ø Importance: ☆☆☆
Ø Content:
• Contango and backwardation
• Theories of commodity futures returns
Ø Exam tips:
• 理解期货溢价和现货溢价
• 重点掌握大宗商品期货回报理论
 Returns of Commodities Futures
Tasks:
Ø Describe, calculate, and interpret the components of total returns for a
fully collateralized commodity futures contract
Ø Contrast roll returns in markets in contango and markets in backwardation
 Components of Futures Returns
The total return on commodity futures include:
Ø price return (spot yield) is the change in commodity futures prices, generally
the front month contract
price return = (current price - previous price)/previous price
Ø roll yield is the return generated by contract replacement
near termfutures closing price - farther term futures closing price
roll return  ´ percentageof the position being rolled
near termfutures closing price
• investors cannot construct a portfolio including only roll returns
• roll return is a portion of total return for a fully collateralized futures
contract
Ø collateral return is the yield for collateral
 Example 1
consider the roll from the March contract to the April contract for WTI Crude
Oil on 7 February 2014, which rolls its positions over a five-day period (so 1/5
= 20% per day):
Ø March contract closing price: $99.88/barrel
Ø April contract closing price: $99.35/barrel
Solution:
Ø ($99.88 – $99.35)/$99.88 = 0.53% gross roll return × 20% rollover portion
= 0.11% net roll return
 Example 2
An investor has a $10,000 position in long futures contracts for soybeans that he
wants to roll forward. The current contracts, which are close to expiration, are
priced at $4.00 per bushel whereas the longer term contract he wants to roll into is
priced at $2.50 per bushel. What are the transactions—in terms of buying and
selling new contracts—he needs to execute in order to maintain his current
exposure?
A. Close out (sell) 2,500 near-term contracts and initiate (buy) 4,000 of the longer-
term contracts.
B. Close out (buy) 2,500 near-term contracts and initiate (sell) 4,000 of the longer
term contracts.
C. Let the 2,500 near-term contracts expire and use any proceeds to purchase an
additional 2,500 of the longer-term contracts.
 Solution
A is correct. To roll over the same level of total exposure ($10,000), he will need
to do the following:
Sell:
$10,000/$4.00 per contract = 2,500 existing contracts
And replace this position by purchasing:
$10,000/$2.50 per contract = 4,000 existing contracts
 Contango, Backwardation, and the Roll Yield
Ø roll yield generally is positive in backwardation, but negative in contango
Ø empirically, roll return have an important impact on any single period return
but overall has been relatively modest compared with price return
Ø roll return is very sector dependent thus sector diversification or
concentration have a profound impact on overall roll return
Summary
Ø Importance: ☆☆☆
Ø Content:
• Components of commodities futures returns
Ø Exam tips:
• 重点掌握大宗商品期货投资回报各组成部分的解释和计算
 Commodity Swaps and Indices
Tasks:
Ø Describe how commodity swaps are used to obtain or modify exposure to
commodities
Ø Describe how the construction of commodity indexes affects index returns
 Commodity Swaps
Ø a commodity swap is a legal contract involving the exchange of payments
over multiple dates as determined by specified reference prices or indexes
relating to commodities
Ø swap provides risk management while eliminating the need to set up and
manage multiple futures contracts
Ø swap provide a degree of customization not possible with standardized
futures contracts
Ø the dealer of swap may hedge its price risk through the futures market,
negotiating its own swap with another party, or using a physical purchase
contract with a commodity producer
 Commodity Swaps
Classification of commodity swaps:
Ø excess return swap
Ø total return swap
Ø basis swap
Ø variance swap
Ø volatility swap
 Commodity Indexes
Key characteristics that differentiate commodity indexes
Ø the breadth of coverage (number of commodities and sectors) included in
each index
Ø the relative weighting assigned to each commodity, and the methodology
for how these weights are determined
Ø the rolling methodology for determining how those contracts are rolled
over into future months
Ø the methodology and frequency for rebalancing the weights
Ø the governance of indexes
Summary
Ø Importance: ☆
Ø Content:
• Commodity swaps
• Commodity indices
Ø Exam tips:
• 了解不同种类的大宗商品互换
• 了解大宗商品指数构建特征